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Tuesday, July 1, 2008

Italy's Economy On The Ropes (Again)

"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."

Altogether, the long-run data suggest that the bad performance of the Italian economy is not the figment of the currently unfortunate business cycle contingency. This is why speaking of decline may not be totally unwarranted. With one caveat to add, though: given that the rest of Europe has been and is still growing at a positive pace, Italy’s alleged decline is of a relative, not an absolute type. Italy’s per-capita GDP has simply grown not as fast as Europe’s GDP, but has not diminished over time (yet)"

Francesco Daveri and C. Jona-Lasinio,
Italy's Economic Decline, Getting the Facts Right

The Swiss writer Frederich Dürrenmatt tells a joke somewhere. It relates to the tragically flawed expedition that Scott lead to the Antartic in the early years of of the last century. There are various possible approaches to the fictional treatment of this topic. Shakespeare might perhaps have Scott fail due to problems which are deeply rooted in his character. Brecht on the other hand would probably have explained the failure as being rooted in some kind of turmoil produced by the class struggle. Samuel Beckett would more than likely have reduced the whole thing to some sort of "endgame", with Scott being frozen in a block of ice surrounded by his crew members equally trapped in other blocks of ice to which Scott speaks without ever receiving any kind of response or answer. Then there is Dürenmatt's own version: Scott's expedition simply failed due to one stupid mistake made right at the outset - Scott accidentally locks himself inside a refrigeration chamber whilst purchasing provisions for the expedition.

Very amusing you might say, but what has this exactly got to do with Italy? Well Italy's economic expedition, like Scott's naval one, is, it seems, essentially flawed. And we have various explanations going the rounds to help us to understand why this is. The Shakesperian version would have it that the whole thing is down to character, you know, all that excessive interest in under the table money and things like that. Then, of course, you have the Brechtian account. Italy's longstanding love/hate relationship with the latter day heirs of former fascist and communist movements, and the veto power vested in the extremes when you have a badly fragmented political system. Then you have the more intellectualised Brussels/Brechtian account, which would put the whole problem down to Italy's failure to really enter into the spirit of the Lisbon Reform and Dialogue Process. Then of course there would be the accidental spanner in the historical works account ,whereby Italy simply got locked out of modernity before it even got started. I think the smart name for this would be "path dependence", with Italy, say, being forced out of ERM in 1992 by one very smart decision by one very well known investor, and the rest, as they say, now being history.

Curiously, with or without the plethora of would-be explanations we have on offer, there is a least consensus on one thing: something is wrong with the Italian economy, badly wrong. But before getting into my own "scripting" of what is actually going on Italy, lets start from the ground floor and take a look at some of the basic facts of the case.

Italy's Growth Decline

The first thing to notice about Italy's economy is its more or less endemic weakness. If we look at the chart for quarter on quarter growth since 2000 (see below), what is evident - and regardless of whether or not Italy is actually (technically speaking) in recession right now - is the fact that Italy has already been in recession three times so far this century (and sometime this year it will almost certainly be in for a fourth, and in 2009 a fifth?) - in Q2/Q3 2001, Q1/Q2 2004 and in Q4 2004/Q1 2005. It is the fragility of this situation which is so noteworthy I beg to suggest.

If we look at the long term GDP growth chart the position becomes even clearer, since after pretty strong - if rather volatile - growth in the (1950s, 1960s - see Davieri and Jona-Losinio, and) 1970s, Italian headline GDP growth has been more like a flame which is steadily going out - the proverbial candle in the wind. Just one hefty puff and it is gone, it seems to me. And the current combination of the ongoing credit crunch (tighter lending conditions) and the global food and energy "shock" may well constitute just the strong puff that was needed. (Although I'm not sure that "shock" is quite the right term here, since normally shocks are considered to be exogenous, while looked at from the perspective of the global economic system rather from that of individual national economies, what is happening might well be though to be endogenous. I think this argument will have to await another occasion, although I do have a shot at putting an initial case here).

Basically if we look at the trend here, and in particular if we think about how frequently the Italian economy has been dipping in and out of recession over the last seven years, we ought at least be prepared to ask ourselves the question whether a point might not arrive when Italy enters what appears to be a recession and then never comes out, in the sense that we don't get to see sustained positive headline growth again, and the economy simply contracts and contracts. Of course, if this were to be the case we would need to revise our historic vocabulary, since what we would be facing would certainly be far more than a mere recession, while at the same time it is quite unlikely that what we will have could be described as a slump, in the sense that after a slump we normally get a rebound). Rather, and in similar fashion to the emblematic Venice itself, the Italian economy may slowly but surely be simply sinking into the sea.

Certainly the theoretical possibility of such an eventuality does exist, and the far from hypothetical possibility of such a state of affairs actually coming to pass in reality should not be simply discounted, since with the coming decline in the labour force as the Italian population ages and shrinks, and the decline in things like retail sales which may accompany an ever reducing number of consumers, it isn't hard to see how this might happen. If we simply take the issue from the supply side for the moment it is plain tha, barring immigration, raising productivity is just about the only way Italy can hope to sustain growth momentum in the future, and productivity growth is precisely what Italy hasn't been delivering in recent years. As we can see in the chart below, output per hour worked in Italy has been steadily losing ground vis-a-vis the other members of the EU 15 since the mid 1990s.

And if we look at the annual rates of change in GDP per hour we get a chart (see below) which looks remarkably similar to the one we saw above for long term GDP growth.

Viewed From The Supply Side

Now this comparative performance vis-a-vis the EU 15 is the exact opposite of the one we should be seeing, given the fact that Italy is in the short term the most challenged of the EU economies in terms of potentially labour supply (see chart below). Between 2010 and 2020 the working age population is set to decline by around 1.5 million. So, given the supply side constraints on labour, if Italy is to avoid slipping into long term economic contraction then the whole productivity trend has to be reversed, and this is no easy matter and something, frankly, which it is hard to see actually happening after so many years of talking so much and doing so little. (In this regard it is far from clear whether eurozone membership has provided Italy with sufficient incentive for change, or whether - by guaranteeing cheap liquidity - membership has simply allowed Italy's problems to continue and the underlying stituation to deteriorate as argued by OECD economists Romain Duval and Jørgen Elmeskov in their well known paper " The Effects of EMU on Structural Reforms in Labour and Product Markets" presented at the ECB Conference "What effects is EMU having on the euro area and its member countries?" held in June 2005).

Obviously this labour supply constraint can be circumvented in the short term by raising participation rates and immigration (although in the longer run sustainability implies that something serious needs to be done about the underlying low fertility issue). However it needs to be said that progress so far in this direction has certainly been far from satisfactory. As can be seen from the next chart, Italy has had quite a dramatic surge in immigration in recent years.

Employment in Italy has risen from 20.617 million in Q1 2000 to 23.170 million in Q1 2008. That is there has been an increase of about 2.5 million (or 12.4%) in the number of those employed, so Italy has been creating jobs, but this has largely been in labour-intensive, low-value activities, and hence the productivity result. More to the point, since Q1 2005 Italy has generated 800,000 extra jobs, and 500,000 of these positions have been filled by immigrants. That is, the Italian labour force itself is nearly stationary at this point.

And Then From The Demand Side

What little economic growth Italy gets these days largely comes from two things: exports and government spending. Since the prowess of the former continually shows evidence of ongoing weakness (see here), while the latter is already responsible for the second largest debt to GDP ratio on the planet (or the third, depending on whose version of the Greek accounts you accept), it is plain that demand side elements in the Italian case are inherently weak. If we take Q1 2008 as an example, GDP was up by a seasonally adjusted 0.5% on Q4 2007, which seems to be a relatively positive result. But when we come to examine the details things don't seem to be so rosy at all. Imports were down 0.5% on the quarter (due to weak internal demand), while exports were up 1.4% (this was the positive part). As a result the balance between imports and exports changed substantially, and this is undoubtedly one of the main factors in the "bounce back" in the first quarter from the 0.4% q-o-q contraction registered in Q4 2007.

Total consumption was up q-o-q 0.2% (all data seasonally adjusted), but it is the composition of the consumption that matters here, since private household consumption was only up 0.1% (after falling 0.4% q-o-q in Q4 2007) while government consumption and transfers were up 0.4% (that's a 1.6% annual rate in an economy that is hardly growing). It is hard to see how this rate of increase in government consumption can be maintained and the deficit be reduced at one and the same time.

Investment is basically a second order factor here, since this will rise and fall as either exports or domestic demand generate the impetus to justify the invesment. Gross Fixed Capital Formation was down q-o-q by 0.2% in the first quarter, of which equipment was stationary, transport equipment down 3.4% and construction up 0.3%. However when we come to look at year on year machinery and equipment (ie investment and renewal) spending, we find it was down 0.9% following an annual 2.5% drop in the previous quarter. That's why all those business confidence readings are so important, since in many ways the bottom has all but fallen out of Italian investment in machinery and equipment over the last nine months, and to get this item moving again we are going to need to see a revival in confidence, something which is unlikely to appear over any immediate horizon. Italian business confidence dropped to its lowest level in almost three years in June under the impact of slowing economic growth, rising energy costs and a stronger euro. The Isae Institute's business confidence index dropped to 87.1 from a revised 89.4 in May. That is the lowest reading since July 2005.

On the export side Italy is no Germany or Japan, and struggles to sustain a trade balance, there is often a goods trade surplus, but a significant deficit on services (especially in transport and business services) means that Italy normally runs a trade deficit these days.However the fortunate combination of reduced imports and increased exports sometimes means that the trade impact on headline GDP is positive, and we see economic growth. The dynamic can be seen to some extent in the chart below - which shows movements in GDP, investment in machinery and equipment and exports. The uptick starts with a movement in investment, which is presumeably a response to changes in the order books, then exports surge, and in their wake headline GDP moves up. Then the rate of increase in exports starts to weaken, investment hits a downward path, and some quarters later GDP folds. Now investment in capital and equipment, while still falling year on year, did bottom in Q1, but here comes the rub, with the external environment worsening, and the storm clouds gathering this may well not have been sustained into an uptick. And viewed in this light the fact that the June business confidence reading fell back again might be thought to be rather ominous.

Returning now to consumption we can see in the chart (below) that the dynamic behind Italian household consumption has steadily faded in recent years (in a way which reproduces the pattern seen in the long term GDP growth and productivity charts). This is why I say the only real possible first order drivers of growth for the Italian economy are exports and government spending, since both investment and consumer spending tend to be derivitives of these.

As far as retail sales go, these were down by 5.9% in real terms in April (the latest month for which we have ISTAT data), while the retail PMI has now been registering contraction for 16 consecutive months. The June figure suggests another strong contraction (36.3) but not as rapid as the April one (31.4). Again, we could ask ourselves whether Italian retail sales will ever grow again, especially since they were mainly contracting in real terms though most of 2006/07 which was one of Italy's best growth spurts in the century so far.

As far as housing booms go Italy has not had a real boom since the one which took place between 1985 and 1992. The housing market does however continue to limp along, and construction activity is a GDP positive. Nationally, prices in 2007 rose by around 4% in nominal terms, much the same as the previous year, while the number of sales dipped by 4% falling to roughly 16% below their 2004 peak.

Prices in the major cities have been growing somewhat faster than the national estimates in recent years but are considered by both Nomura and Scenari to have grown by at less than 5% in 2007. Over the past decade, house prices have not risen at anything like the rate seen in many other EU countries, and only grew by about 30 to 40% in real terms between 1996 and 2006.

Pensions Retirement and Debt

So to tie all this up (neatly if possible) where does my analysis leave us? Well Italy badly needs to turn the productivity problem around, and there are, naturally, as many suggestions around about how to do this as there are explanations for her plight. Unfortunately most of the suggestions have been on the table for rather a long time now, and nothing noticeable has happened. So what confidence can we have that things will be any different this time round? Very little I would say.

In Chapter Two of its Italy country note "Economic Policy Reforms: Going for Growth 2008" the OECD did outline a long list of priorities for Italy. In order increase productivity, the OECD recommend that: divesture programmes be accelerated in public utilities, transportation and media; golden shares be replaced with arm’s length regulation; and regulators be strengthened further: planned liberalisation of market and local government services be fully implemented, and statutory and official authorisations giving anti-competitive powers to professional associations be removed. The OECD also advocate a decisive push to boost tertiary education graduation rates and improve university teaching and research quality. All such measures are doubtless very worthy, and will produce some results if implemented. But it is not at all clear that, even with decisive government action (which is not at guaranteed at this point, indeed interest seems rather to be focused on "Robin Hood" taxes and other such like) they will go deep enough and take effect rapidly enough to stave off what is likely to become the number one issue of the day: the sustainability of Italy's fiscal debt.

In order to appreciate the depth of the problem here, we might just take one area: pensions reform. As we have seen, after many years of very low fertility, fewer and fewer young Italians are now joining the workforce to replace the older Italians who are retiring. Instead their places are now being taken by a steady stream of newly arrived immigrants. In fact two-thirds of the annual increase of 308,000 new workers in the fourth quarter of 2007 were immigrants, with the other third being effectively accounted for by an increase in employment rates in the 55 to 64 age group. At the same time Italy has the highest proportion of over 65 year olds in the European Union and the second highest in the OECD (after Japan).

Italian civil society is effectively in denial, however, about the importance of this problem, and the best illustration of this is the ongoing failure to reach agreement on substantial increases in the retirement age - indeed despite all the recent "anti-immigrant" rhetoric we have been hearing coming out of Italy the fact of the matter is that a very large share of the new employment has gone to immigrants, and these immigrants are effectively working to pay a significant chunk of the pensions bill being run up by all those Italians who are still taking their retirement at 58 (only to live and claim their pensions a lot longer than most other Europeans to boot). Yet one more time Italy is more or less at the head of the list (see chart below) in terms of early exit from the labour force.

In fact one of the big problems for the Italian political system in its attempts to do something to address the downward drift in the economy is all the political horse trading that is needed to move even the smallest change forward. Last November Prodi only finally managed to get the support of Italy's labour unions for the 2008 budget (which was of course an attempt to keep the fiscal deficit under control) by accepting that there would be a much more gradual pace of increase in Italy's pension and retirement age as a trade off. The agreement he reached involved a staggered increase in the minimum retirement age, which at that point was set at 57. The change in fact involved supplanting (or going back on) a previously agreed reform law - one which would have boosted the retirement age to 60 from as early as January 2008 - and an effective slowing down of the reform process. The law which was put aside was agreed to in 2004, by one of Silvio Berlusconi's governments, and the decision taken then had been to raise the minimum retirement age— from 57 to 60 - as of January 2008. Under the new Prodi plan the retirement age was raised by one year, to 58, in 2008. In July 2009 the retirement age will again go up, this time to 60 for those with 35 years of contributions, or remain the same for those workers who can muster 36 years of pension payments. From 2011, the retirement age for everyone will rise to 60, and then to the astronomic age of 61 by 2013.

This decision, apart from being an astonishing one for outside observers, raises a number of important issues, especially since the ageing population problem is one which affects Italy in a very important way. Male life expectancy in Italy is now fast approaching 80, and is among the highest in the EU. At the same time Italy currently has the third-lowest birth rate in the EU (TFR around 1.3). Without raising the retirement age, contributions simply won't keep pace with pension payments (which are already running at approximately 15% of GDP see chart below) over the coming years, even assuming there is no ageing impact on the overall economic growth rate, which as we are seeing is far from clear.

Of course doing things in this way is not only ridiculous, it is also totally unsustainable. Italy undoubtedly needs migrant labour, but as a complement to, and not a replacement for, a very substantial and swift increase in the retirement age and in employment participation rates among the over 60s. The consequence of not addressing the retirement question is obvious: Italy's debt - which did fall back slightly in 2007 (to 104 percent of GDP from 106.5 percent in 2006) will start to rise again.

Interest payments alone on the national debt currently run at some 70 billion euros a year, or about 1,200 euros for each Italian, and any serious slippage in fiscal "clean up" is going to be closely watch by the financial markets, where, it will be remembered, the difference in yield between Italian 10-year bonds and the benchmark German bunds tends to increase notably at the first sign of risk aversion in the global financial markets. The spread between German and Italian bonds widened to 52 basis points in mid March, the most since October 1998, when it was as by much as 61 basis points. Any repetitions of this incident will surely cost the Italian government dear, since spending programmes - like the pension system that already eats up a full 15 percent of GDP - will almost certainly become more expensive to fund, leading to cuts in other - less protected and less structural - areas.

Any mention of rising Italian government debt only piles on the risk to Italy's credit rating. Both Standard & Poor's and Fitch Ratings reduced Italy's creditworthiness in October 2006. Fitch now rates Italy's long-term debt AA-, while S&P gives it A+. Italy's debt is rated 'Aa2' with a stable outlook by Moody's. Italy's issue with the ratings agencies is liable to prove no mean one, as the ECB made clear back in November 2005, when it took the decision not to accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies.

Only this week the Italian employers association, Confindustria, cut their forecast on the Italian economy for 2008, suggesting it will effectively grind to a halt this year economy and grow by the miniscule 0.1 percent this year, the slowest pace since 2003. Even more importantly they suggested that the slowdown in growth will simply add to the strain on Italy's public finances. They forecast Italy's budget deficit in 2008 will rise to 2.5 percent of gross domestic product compared with its previous forecast in December of 2.2 percent. This is really the number of all numbers to watch, since Italy desperately needs to avoid a deficit of over 3% if it wants to stay out of trouble with the debt ratings agencies. Confindustria predicts that Italy's deficit will increase to 2.6 percent in 2009, in the process casting doubt on the government's ability to balance the budget by 2011 as required by EU agreements. So I guess this is our "risk barometer" on Italy. Each tenth of a percentage point the Italian deficit climbs over that 2.5% forecast will represent one more nail in the coffin of S&P's A+ rating, and will put Italy one small step nearer having the doors of the vaults over at the ECB slammed firmly shut in the face of Italian government paper.

1 comment:

Anonymous said...

A very interesting analysis of Italy's economic woes. As you say, consistent government inaction has not helped one jot.

Things are looking rather bleak for the 'Living Museum' as I call it.

And recent 'reform' proposals by Italy's government appear to involve cuts which will have a destructive effect on what is already a somewhat fragile situation.

Good management is what is needed in Italy, not aesthetically pleasing ministers.

Kind regards,